Leveraged ETFs

Over the past 10 years, utilization of exchange traded funds has grown to the point that most investors have at least one ETF as part of their portfolio. While this is a step in the right direction for the investing community, there is one type of ETF that should never be used by the long term investor: Leveraged ETFs. Since the financial crisis of 2008, leveraged ETFs have exploded in popularity amongst both retail and institutional investors. On the surface, this may not seem all that dangerous. However, without proper education on this type of ETF, investors might suffer losses even when they have the correct idea on the future of the markets. How is this possible? Well let's take a look at the most recent warning on ETFs delivered by none other than the SEC

Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25 percent.

During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent. An ETF seeking to deliver three times the inverse of the index's daily return declined by 90 percent over the same period.

What?

If an index gains 2%, and I'm holding an ETF that guarantees me 2x the performance of the index, my leveraged ETF will be up 4%, correct?

Nope.

Fortunately, warnings from the SEC have applied significant pressure on leveraged ETF issuers, such as ProShares, to significantly upgrade the educational resources on their website. As per ProShares:

This Short ProShares ETF seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their holdings consistent with their strategies, as frequently as daily.

This key word in the above statement is: for a single day. Due to this factor, a "2x leveraged ETF" will not perform twice the amount of the underlying index over the long run, but rather will achieve a return that is highly affected by large daily fluctuations.

Unfortunately, few people actually read the prospectuses of the ETF in which they are investing their hard earned money. In an article from Reuters this year Ashley Lau writes, "Leveraged exchange-traded funds, originally viewed as tools for fast-moving day traders, are showing up more frequently as buy-and-hold investments in Mom and Pop portfolios, thanks to the advisers who are putting them there." This use by financial advisors is not only imprudent for retail investors, but highly risky from a financial advisors perspective. Suitability is large part of any financial advisors responsibility, and by including leveraged ETFs in mom and pop portfolios, such financial advisors are setting themselves up for lawsuits should these ETFs not track 2X the index over the long haul.

Let take a look at a chart provided by Capital Cube of the performance of a leveraged ETF versus a plain vanilla one. The ProShares Ultra Oil & Gas (NYSE Arca:DIG) here is compared over the past 3 years to the Energy Select Sector SPDR Fund (NYSE Arca:XLE); as can be seen in the chart, XLE is up 34.84%. Theoretically, we would expect DIG, the 2x leveraged Energy ETF tracking the same index to be up 69.66%, but because of the daily reset factors (among others) that is not the case. DIG has returned only 51.68% over the same time period.

Also consider that DIG has a net expense ratio of 0.95% compared to 0.16% for XLE. On the risk - reward spectrum view the significantly higher volatility of the leveraged DIG as compared to the XLE:

In conclusion, Leveraged ETFs have legitimate purposes for large, institutional investors to hedge themselves intra-day. However, daily resets, derivative risks, and higher expense ratios make Leveraged ETFs not viable for the long term. Retail investors looking for long term performance should stay as far away from these instruments as possible.

The views and opinions expressed above are those of the author and do not necessarily reflect the views of CapitalCube.com, AnalytixInsight, Inc., its affiliates, or its employees.